Live long and remain quite prosperous

Robert J. Shiller, Project Syndicate

Living a long time is one of our deepest wishes, and medical and economic progress offers the hope that it will be fulfilled. Some scientists say that the average human lifespan could reach 90 years or more by mid-century. But what if our wish is granted? What good is a longer life if we cannot maintain our standard of living?

The fundamental difficulty in planning for enhanced longevity is that we do not know whether it will really happen. Life expectancy might well be only 80 years by mid-century-- about where it is now in advanced countries-- if medical progress is disappointing or is offset by new threats or hazards.

If we make provisions for long lives that are cut short, we will have wasted huge amounts of precious economic resources. But if we fail to make provisions for lives that are longer, many elderly people will be condemned to poverty.

The whole direction of any country's economy depends on longevity. A huge number of elderly people would mean a lot of people wanting to live in certain locations, seeking certain kinds of living quarters, and consuming certain kinds of services. The types of corporations that will succeed, the buildings that are constructed, and the research and development that will be needed all depend on the demographics of demand.

This is true of the global economy as well. In his 2005 book The Future for Investors, Jeremy Siegel argues that differences across countries in longevity will interact with differences in wealth levels to form a fundamental determinant of economic relations among countries.

Trade flows may be driven substantially by longevity: countries expecting a relatively large number of elderly in the future should be running trade surpluses now and deficits later.

Retired people need life annuities-- contracts that offer a stable income stream for as long as they live-- to insure against the risk of outliving their wealth. If there were no longevity risk-- that is, if the probability of dying at each age in the future were reliably known-- then pension funds could easily offer life annuities to large numbers of people by investing their assets in bonds of various maturities in order to pay out just the right amount each year.

But pension funds cannot do this, because they risk running out of money if, on average, people turn out to live longer than expected. For people retiring at age 60, the difference between living to 80 and living to 90 is enormous: in the latter case, their pensions would have to pay benefits for 50 percent longer. As a result, private companies do not offer life annuities at attractive rates, because they cannot be reasonably sure that they can fulfill their promises unless they are significantly overcapitalized.

Fortunately, financial markets are beginning to address longevity risk. In November 2004, the European Investment Bank (EIB), working with the private bank BNP Paribas, announced that it would issue the world's first long-term longevity bond. The bonds, with a maturity of 25 years, pay out an annual sum of 50 million euros multiplied by the percentage of the English and Welsh male population aged 65 in 2003 that is still alive in a given year (subject to a slight data lag).

For example, if 80 percent of the men are still alive ten years after issuance, the bonds will pay out 40 million euros. If only 40 percent of the men are still alive after twenty years, the bonds will pay out 20 million euros.

BNP Paribas hoped to place the bonds with UK pension funds, but so far the issue has not been fully subscribed. Most of the likely buyers are slow to make up their minds, since trustees, fund managers, consultants, and employer sponsors must all become comfortable that the new concept is consistent with their fiduciary obligations.

Moreover, it is not clear that the EIB can get further help from reinsurers in managing the risks it assumes by issuing such bonds because reinsurers do not yet see how they can fully hedge the risks involved.

The slow launch of longevity bonds ultimately reflects a fundamental question: can we genuinely reduce the impact of longevity risk? If everyone is affected by longevity risk in the same way, then no matter what the price of a longevity bond, everyone should logically want to be on the same side of the contracts-- all buyers at one price, all issuers at another. No difference means no market.

But, in fact, we are not all affected by longevity risk in the same way. Life insurance companies, drug firms, businesses providing services for the elderly, and investors in retirement real estate would all benefit from increased longevity, while defined-benefit pension plans and annuity providers would lose.

Less affluent individuals are also more threatened by longevity than those for whom living longer mainly means leaving a smaller inheritance to their children. Indeed, countries with higher birth rates are less exposed to longevity risk in the next half-century or so than countries with low birth rates.

We thus need a large and liquid market for longevity risk so that these different groups can creatively share their risks with each other. In fact, creating such a market is the most important step we can take to address longevity risk, for we could then discover its true price, allowing myriad business decisions involving longevity to be made more efficiently.

There is virtually no history of the price behavior of longevity bonds, so discovering their buyers and sellers, and the prices that clear the market, will take some time. But longevity bonds, while only experimental today, will eventually become vitally important to the world economy.

Robert J. Shiller is Professor of Economics at Yale University, director at Macro Securities Research LLC, and author of Irrational Exuberance and The New Financial Order: Risk in the 21st Century.